SPECIAL REPORT - What triggered oil's biggest rout

A fuel pump nozzle lays in a puddle of gasoline after it was disconnected from the hose at a station in Arlington, Virginia, June 11, 2008.
REUTERS/Jim Young/Files

By Joshua Schneyer| NEW YORK

NEW YORK When oil prices fell below $120 a barrel in early New York trade last Thursday, a few big companies that are major oil consumers started buying around $117.

It looked like a bargain. Brent crude had been trading above $120 for a month. But the buying proved ill-timed. Crude kept on falling.

"They were down millions by the end of the day, trying to catch a falling piano," an executive at a major New York investment bank said.

Never before had crude oil plummeted so deeply during the course of a day. At one point, prices were off by nearly $13 a barrel, dipping below $110 a barrel for the first time since March.

Oil's descent followed the biggest one-day price drop in silver since 1980 on Wednesday, after hedge fund titan George Soros was reported to be selling. Exchange operators raised silver's margin requirements, making it more costly to trade the metal and sending investors out of the market. Silver plunged by 20 percent, more by week's end. The rout unnerved some commodity investors.

Oil just doesn't fall by 10 percent in the course of a normal day, though. In commodities markets, oil is king, and its daily contract turnover, typically around $200 billion, is usually able to absorb even large inflows or outflows of investment.

The rare moves of $10 a barrel usually are set off by dramatic events -- the outbreak of the first Gulf War in 1991, or the collapse in 2008 of Lehman Bros bank, which both led to recessions.

Of course, there was major news last week. But the daring Pakistan raid that killed Osama bin Laden had done little to shift the balance of oil markets on Monday.

In interviews with more than two dozen fund managers, bankers and traders, no clear cause emerged for the plunge in price. Market players were unable to identify any single bank or fund orchestrating a massive sale to liquidate positions, not even an errant trade that triggered panic selling, as seen in the equities flash crash last May.

Rather, the picture pieced together from interviews on Thursday and Friday is one of a richly priced commodities market -- raw goods have been on a five-month winning tear over all other major investment classes -- hit by a flurry of negative factors that individually could be absorbed but cumulatively triggered a maelstrom.

Computerized trading kicked in when key price levels were reached, accelerating the fall.

"It was a domino effect," said Dominic Cagliotti, a New York-based oil options broker.

The negative factors -- prominent cheerleaders turning bearish, some weak economic data, cheap money from the U.S. Federal Reserve ending by July, a lessening of political risk -- merely provide a backdrop for the waves of selling. What stands out is the way computers turned readjustment of positions in a huge and deep market into a rout.

THE COMPUTERS

Stunningly large jolts from so-called stop-loss trading amazed market traders. The automated sell orders were generated as oil crashed through price points that traders had programmed in advance into their supercomputers. In many cases, computer algorithms sold for technical reasons, as oil dropped through levels that, once breached, could trigger ever larger waves of selling yet to come.

The machine trading, based on subtly different but fundamentally similar, algorithmic models, eliminates the white-knuckles and potential human error involved in actively trading a volatile market, and increases anonymity. Instead of breeding hesitation, abrupt price drops can quickly prompt these machines to unload a bullish long position in oil, and build up a bearish short one instead.

Machine-led trading is one plausible thesis for another apparent market anomaly that occurred on Thursday. Exchange data shows that the total number of open positions in the oil market -- a number that would typically fall in a selloff -- instead rose. Normally, panicky funds selling oil en masse would cause total "open interest" numbers to shrink, as exiting investors closed out contracts. But some machines, following the market trend, may have gone further, by dumping long positions and quickly amassing sizable short positions instead.

"Computers don't care. Momentum just increases until nobody wants to stand in front of it," said Peter Donovan, a floor trader for Vantage on the New York Mercantile Exchange.

Some big Wall Street traders watched their own systems sell into the down trend but couldn't know for sure who had initiated the selling spree. They only knew that similar machines at other firms, from New York, to London, Geneva and Sao Paulo, would be automatically selling in much the same manner.

During Thursday's crash, such selling locked in profits that high-flying commodities traders have been accumulating for months. Some of Thursday's rout appears to have been more a product of the wisdom of crowd computing than of widespread human panic.

"We believe the magnitude of the correction appears in large part to have been exacerbated by algorithmic traders unwinding positions," Credit Suisse analysts wrote in a report.

High frequency trading and algorithmic trading accounts for about half of all the volume in oil markets.

BIG NAMES TURNED BEARISH

Some of the seeds for the rout were sown earlier. In April, Goldman Sachs' bullish team of commodities analysts, led by Jeff Currie in London, issued two notes to clients in rapid succession recommending they pare back positions. In one, the bank called for a nearly $20 dollar near-term correction in Brent oil, while maintaining a bullish longer-term outlook.

The closely watched money king, George Soros, who runs a macroeconomic hedge fund, had said for months that gold was pricey. Even online advisors to mom-and-pop investors such as The ETF Strategist had warned of a bubble in precious metals that could be ready to pop.

On Wednesday, the Wall Street Journal had reported the Soros Fund was selling commodities including silver, and four sources from other hedge funds told Reuters they believed Soros was busy selling commodities positions again on Thursday.

Silver markets already had suffered four days of carnage and ended the week down nearly 30 percent. But silver is a tiny market, much more susceptible to sharp price moves. Some traders suspect that big holders were cashing out of the least

liquid commodity market first, before moving onto the big one - oil.

As crude crashed on Thursday, it dragged down every other major commodity. The Reuters Jefferies CRB index, which follows 19 major commodities, was on its way to a 9 percent weekly drop, the biggest since 2008.

Oil's selloff began in London, and accelerated as New York traders piled in.

A routine report on U.S. weekly claims for unemployment benefits spooked investors, showing the labor market in worse shape than expected. That fed a growing pessimism about the resilience of the global economy after industrial orders slumped in Germany and the massive U.S. and European service sectors slowed. Then the European Central Bank surprised with a more dovish statement on interest rates than expected, signaling its wariness about the euro zone outlook. The dollar rose sharply.

Before noon New York time, Brent crude oil prices were already trading down a jaw-dropping $8 a barrel.

Fourteen hundred miles southwest of New York's trading floors, on Texas refinery row, oil men were stunned by the drop, which played havoc with their pricing models.

"It was nuts. Our risk management guys were tearing up their spreadsheets," said a major U.S. independent refiner, who asked not to be identified.

A range of factors, both economic and political, were also at play. The recent rise in raw goods has been fueled in part by the U.S. Fed pumping cash into the markets by purchasing $600 billion in bonds. This program has pushed interest rates extraordinarily low, making borrowing essentially free once adjusted for inflation. Investors have been using the super-cheap money to buy into commodity markets. But the Fed's program is slated to end on June 30.

"Funds were likely to take profits before June when the direct (Fed) bond purchases stop. All were eyeballing each other to see who would take profits first," said a London-based oil trader.

China, the world's fastest-growing consumer of commodities, also is tightening monetary policy to tamp growth rates and control inflation, raising the prospect of a slowdown in demand for oil.

The political risk premium built into oil prices also came under scrutiny last week. The unrest sweeping through the Arab world - home to over half of world oil reserves - has boosted oil this year. The only major supply disruption so far is from Libya, where war has cut off at least 1 million barrels a day.

"We've been in a world thinking there's more risk, more risk, more risk," said Sarah Emerson of Energy Security Analysis Inc. "People took this week, and the news of bin Laden's death, to simply reflect. They stopped and said, maybe there's less risk."

GAME OVER

Put all these factors together, and they amounted to a reason to sell. Traders and brokers who spoke with Reuters speculated that macro funds like Soros and others, which had been aggressively overweight commodities, were cutting the portion of their portfolio allocated to commodities. Because those positions had grown so large, even a small rebalancing would amount to billions and billions of dollars in contracts sold. After weeks of thin trading in Brent oil futures, Thursday's trade volume hit a record.

Early Thursday, investment advisory firm Roubini Global Economics had also joined the fray, telling clients for the first time in years to cut commodities in their macro portfolios. Many funds were merely taking months of handsome profits off the table.

Yet Thursday's rout certainly produced casualties.

By the afternoon New York time, some of the world's biggest money managers thought they smelled blood. Several banks and funds seemed to be selling oil in an orderly fashion, even if the price drop was extraordinary. But could a hedge fund be struggling for survival?

They wondered whether any major commodities funds were on the losing end of bullish oil bets, and were getting forced by margin calls from brokers into dumping massive positions.

One trader at a major bank in New York called a colleague at one of the world's largest hedge funds. During the conversation, they exchanged notes, suspicious that one or more commodities-focused hedge funds might be facing a moment of reckoning, one of the participants said.

No fund could be pinpointed. By the end of the day, the person said, they were less suspicious -- a view shared by week's end by many market participants who spoke to Reuters. No one was naming a major hedge fund in dire trouble, or a computer trading algorithm that went haywire.

And unlike last May's flash crash in equities markets -- when stocks fell by a similar 9 percent margin in just minutes -- Thursday's decline came in rolling cascades, playing out over at least 12 hours.

Even after Brent fell to settle around $110 by the end of the day, crude prices were still up 38 percent from a year ago.

"Since prices have been advancing well beyond any reasonable measure of value, Thursday's declines felt more like orderly corrections than chaotic panics. There was no sense that anyone was ready to jump from the window," said oil analyst Peter Beutel of Cameron Hanover in Connecticut.

CASUALTIES

The day left some commodities-heavy funds nursing wounds - weekly losses of 10 to 20 percent, according to several fund managers who invest in other hedge funds.

Two of the sources said that London-based BlueGold, a fund known for taking aggressively bullish directional bets on oil in the past, had sizable losses. It was not immediately clear how much the fund dropped, and BlueGold declined comment.

One money manager said of BlueGold's head trader Pierre Andurand: "He's had tougher weeks so I don't think it's game over."

Phibro trader Andrew Hall's flagship commodity fund Astenbeck II, valued at around $2.6 billion at the end of April, suffered a 12 percent loss last week, according to one of the fund's investors. Hall declined to comment.

Fund sources also cited losses at $20 billion Winton Capital, of around 2.2 percent, on Thursday. FTC Capital, a $300 million European commodities fund, lost 4 percent in one of its larger funds, the sources said. Neither fund was available for comment.

In the space of just hours, the drop in the price of crude oil had shaved nearly $1 billion off the cost of supplying the world's daily oil needs. That could be good news for gasoline consumers. But Eric Holder, the U.S. Attorney General who has recently formed a government working group to investigate manipulation in oil markets, had a blunt warning for oil traders. He wants proof the savings are being passed on to end users.

"This working group was created to identify whether fraud or manipulation played any role in the wholesale and retail markets as prices increased. If wholesale prices continue to decrease, fraud or manipulation must not be allowed to prevent price decreases from being passed on to consumers at the pump," Holder said on Friday.

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